Tuesday, August 19, 2008

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody.

If a politico like Carville recognized the fixed income market as an irresistible force, you'd think a Wall Street pro like Henry Paulson would give it the respect it deserves. But peculiarly, he has been acting as if he can bluster his way through a mushrooming crisis of confidence in Fannie and Freddie.

A Barron's report over the weekend saying that the Treasury would buy GSE preference shares (and wipe out equity holders) if the companies failed to raise new equity sent the shares into a downdraft, with Freddie's falling 25% and Fannie's, 22%, triggering a broader market fall in the US that continued overnight in Tokyo. More troubling, GSE debt also fell, as Accrued Interest reported:

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I've heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he's been up to his eyeballs in 100 bond lots today. Haven't heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

In early July, a previous plunge in the companies' shares prompted the U.S. Treasury to announce a package of measures aimed at shoring up investor confidence. Among other things, the Treasury said it would lend money to the companies or make equity investments in them if needed.

"As the secretary has said many times, we have no plans on using the authority," Treasury spokeswoman Jennifer Zuccarelli said Monday, referring to Treasury Secretary Henry Paulson.

This is about as lame as it gets. I'm sure a PR pro could do better, but the right response is reassurance from Paulson himself: the markets are on the mend, yes, there may be bumps but things are getting better, we are on the case, will act if necessary but don't see the need, Freddie and Fannie have plans in progress to improve their balance sheets. That probably wouldn't undo what Barron's hath wrought, but it would halt the slide and produce at least a partial reversal. Investors want to hear that the powers that be are engaged and willing to pull the trigger.

What is even worse from the Adminsitration's standpoint is that savvy observers see the bailout plan as a sham. As the Financial Times reports:

The Treasury dismissed the [Barron's] report as “speculation”. It told the Financial Times it still had no intention of using its newly authorised power to invest in either the debt or equity of Fannie and Freddie. The question is whether it may be forced to do so.

The logic of the plan unveiled on July 13 was that the market would be reassured by the Treasury obtaining authority to invest in Fannie and Freddie, reducing the likelihood that the government would actually have to bail them out....

“Hank Paulson’s gamble is that if the Treasury commits to investing in Fannie and Freddie [if required] it will never have to put money in,” said Alex Pollock, a fellow at the American Enterprise Institute.

In other words, this was all meant to be a bluff. But the markets have called the bluff in very short order. And given the lousy and certain-not-to-get-better-anytime-soon condition of Freddie and Fannie, this outcome was entirely predictable.

What is ever weirder about the Administration's inept denials is that they seem to be quietly moving forward in examining rescue options. A Wall Street Journal editorial, "When Henry Met Fannie," tells us:

Meantime, Treasury claims it has no plans to inject taxpayer money directly into the companies. Even so, Mr. Paulson has quietly hired Morgan Stanley, the investment bank, to look into "appropriate capital structures" if he does decide to sign the blank check that Congress has given him.

Robert Scully, the Morgan banker who will lead the effort, is by all accounts a straight shooter. And he will need to be, given the enormous political pressure he will soon face from Fannie Mae's defenders, both at Morgan and in Washington. Morgan Stanley says it is forgoing any other investment banking business with Fan and Fred while it works for Treasury. But until recently it was among the banks advising Freddie on that elusive $5.5 billion capital infusion.

Morgan Stanley is also home to Kenneth Posner, one of the biggest Fan and Fred cheerleaders on Wall Street. Only last March, the analyst crowed about the "complete defeat" of the "anti-GSE ideologues" -- that is, the people who had been right all long about the reckless risks the companies were taking. Mr. Posner also predicted that Fannie and Freddie would return to breakeven by the third quarter. Mr. Scully shouldn't be caught in the same intellectual area code as Mr. Posner.

Disclosure: I knew Scully early on in his career. He is indeed as upstanding as they come in investment banking (yes, that is an oxymoron), very well regarded.

So why is Paulson unhelpfully (as far as market confidence is concerned) denying that he will salvage the GSEs, yet moving forward to develop plans to do precisely that? Oh, I forgot. The SIV rescue plan. Hope Now Alliance. Getting China to open its financial markets. Having JP Morgan buy Bear for $2 a share. Execution has not been the Adminstration's or Paulson's strong suit. Why should now be any different?

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